Finance: Research, Policy and Anecdotes

The economics of supranational supervision

Consuelo, Wolf and I have been working on this paper for quite some time, but finally have a version that we feel comfortable with to publish as CEPR Discussion Paper.
It is the third (but not last!) of a series of papers that Wolf and I have co-authored on the tension between national bank supervision and cross-border banking, a tension that comes out especially during the failure and resolution of banks, as we show in
our 2013 paper with Radomir Todorov, published in Economic Policy. Does that imply that supranational supervision is a better solution – not so fast, we argue in our theory
paper, published in the International Journal of Central Banking, where we formalize the trade-off between cross-border externalities from bank failure and heterogeneity in the cost of bank failure, where the former makes cooperation if not supervisory
integration welfare improving and the latter welfare reducing.

In the latest paper with Consuelo we take this model to the data. We first hand-collected data on supervisory cooperation among a global sample of countries over
the period 1995 and 2013. The information is at the country-pair level and was gathered from the supervisory bodies' websites and official documents available online. Supervisory cooperation can take many different forms and degrees of intensity. In our work
we distinguish between four (and increasingly intense) forms of cooperation: a Memorandum of Understanding for information sharing and onsite inspection, a College of Supervisors, a Memorandum of Understanding on crisis management and resolution and a supranational
supervisor. We then regress these gauges of supervisory cooperation on measures of cross-border externalities (including foreign bank share, financial market integration and currency unions or peg) and heterogeneities (structure and level of financial development,
political structure, historic links, geographic proximity etc.).

Consistent with theory, we find that higher cross-border externalities between two countries increases both the likelihood of cooperation and the intensity. Distinguishing
between different dimensions, we find that it is all three – cross-border externalities through bank ownership links, spill-over effects through financial markets and linkages within a currency union – that increase the probability and intensity
of cooperation. We also find that higher heterogeneity between countries decreases the likelihood and intensity of cooperation, again consistent with theory, though the economic effect of heterogeneity is less prominent than that of externalities. In summary,
economics matters! Countries are not only driven by politics and history when agreeing to cooperate among regulators, but also by the net benefits of doing so.

We can also use the exercise to predict which countries are likely to
cooperate with each other. Take the European Union. The banking union is currently limited to Eurozone countries, but is – in principle – open to non-euro countries of the EU. Using our model to consider externalities and heterogeneity
of non-euro EU countries vis-à-vis the banking union countries, we would predict most of them not to join the banking union, maybe with the exception of Bulgaria and Denmark, countries with a currency board and a peg to the euro, respectively.